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Lucky Seven: Clarification on the doctrine of common mistake

Energy and natural resources projects often require regulatory permissions and approvals to be obtained at various stages. For example, governmental consent is almost invariably required for a transfer of upstream oil and gas assets (or shares in a company holding upstream oil and gas assets) and, in the context of a construction project such as a power plant or petroleum pipeline, licences and regulatory approvals are usually required before construction or operations can begin. The recent aircraft leasing case of Triple Seven v Azman1 has demonstrated the dangers to parties where (contrary to expectations) such approvals are not obtained and the contract gives one party inadequate protection. This case also provided an opportunity for the High Court to re-state the essential elements of the defence of common mistake. Despite finding that there was "a mistake as to an existing state of affairs", the judge nevertheless concluded that the mistaken assumption shared by the parties was not sufficiently fundamental to the lease agreements so as to render them impossible to perform.

Common mistake is relied upon by parties to commercial agreements when it later transpires that facts that were assumed to be correct at the time the agreement was made were in fact mistaken. If common mistake is made out, it renders the agreement void ab initio, but case law demonstrates that the argument is rarely successful.

In particular, parties should be aware that the defence will not be available where a contract makes provision for, or allocates risk in respect of, the unexpected state of affairs which forms the basis of the alleged common mistake.

Facts

The Claimants entered into two separate agreements (in materially identical terms) with the Defendant, Azman Air Services Limited (Azman) for the lease by Azman of two Boeing aircraft for a period of five years. Both parties understood that the aircraft would be used by Azman to transport passengers from West Africa to the Kingdom of Saudi Arabia for the Hajj and Umrah pilgrimages, commencing that same year (2016).

Several hours after the Claimants and Azman signed the two lease agreements Azman received a letter (dated some days earlier) informing it that the General Authority of Civil Aviation of Saudi Arabia (GACA) had withheld the necessary regulatory approval for Azman to be able to participate in the 2016 Hajj airlift because Azman had not met applicable Saudi economic, security and safety requirements.

Azman refused to accept delivery of either aircraft on the basis that it was not in a position to participate in the 2016 Hajj airlift. Some days later, the Claimants purported to terminate the lease agreements in accordance with the applicable termination provisions and claimed damages for breach of the agreements by Azman. Azman argued that the Claimants were not entitled to damages because the lease agreements were void at common law for common mistake.

The defence of common mistake

The judgment considers two particular elements of the doctrine of common mistake in detail: (i) the fundamental nature of the common mistake; and (ii) the fact that it cannot apply where the contract makes provision for the unexpected state of affairs giving rise to the common mistake.

The essential elements of the doctrine have already been stated and later clarified by the Court of Appeal in previous cases2 . Common mistake can only exist where there is a shared assumption of fact underlying the contract which is fundamental to it, and which resulted in the making of the contract. The mistake must render the subject matter of the contract essentially and radically different from the subject matter that the parties believed to exist. Whilst building on these well-established principles, however, the judgment applies a more comparative approach than previous cases. In particular, the judge stated that "the test determining the application of the doctrine of common mistake is best applied by (a) assessing the fundamental nature of the shared assumption to the contract, and (b) comparing the disparity between the assumed state of affairs and the actual state of affairs and analysing whether that disparity is sufficiently fundamental or essential or radical".

Applying the above formula to the facts of the case, the judge found that there was a mistake as to an existing state of affairs (i.e. that Azman had the necessary regulatory approval to be able to participate in the 2016 Hajj airlift), but the mistaken assumption shared by the parties was not sufficiently fundamental to the lease agreements and did not render the lease agreements essentially and radically different from what the parties understood or impossible to perform. In particular, the fact that the lease agreements were for a period of five years meant that even if Azman was unable to participate in the 2016 Hajj airlift, this would not preclude it from participating in future airlifts during the term of the lease.

Second, the judgment emphasises that the doctrine of common mistake does not apply in circumstances where the contract allocates risk for the particular situation that gives rise to the common mistake. In other words, the defence of common mistake can only apply where there is a gap in the contract in terms of what the parties have expressly or impliedly agreed, since the doctrine only applies in circumstances that are "unexpected and wholly exceptional".

In this case, the judge found that the risk for the failure to obtain regulatory approval from GACA was allocated to Azman by a clause which provided that any failure by Azman to obtain "any consent, authorisation licence, certificate or approval of or registration with or declaration to any Government Entity required in connection with the Operative Documents, including without limitation:… (iv) any airline licence or air transport licence required by [Azman]" would constitute an 'Event of Default' and therefore a repudiatory breach on the part of Azman, thereby entitling the Claimants to exercise various remedies including termination of the leases. The allocation of risk showed that the circumstances that transpired were not unexpected and wholly exceptional.

The judge summarised the essential elements of a common mistake which has the effect of rendering a contract void as follows:

There must have been a substantially shared assumption (which was fundamental to the contract) as to the existence of a state of affairs at the time the contract was concluded.

The assumption must have been wrong at the time the contract was concluded.

There must be a fundamental difference between the assumed and actual states of affairs (such that the contract or its performance would be essentially and radically different from what the parties believed to be the case at the time the contract was concluded, or it must be impossible to perform in accordance with the common assumption).

The parties would not have entered into the contract had they been aware that the common assumption was wrong.

There must be no provision made in the contract which addresses the consequences that apply in the event that the common assumption was mistaken.

Conclusion

It is very common to see contracts in the energy and natural resources sectors that are contingent upon regulatory approvals or licences being obtained. For example, where a governmental consent is required for a transfer of upstream oil and gas assets it is usual for the parties to enter into a sale agreement with a condition precedent to the completion of the sale that the relevant consent is obtained by a specified longstop date. Such conditions precedent and other boilerplate contractual provisions will become binding on the parties on signing, but the operative sale and purchase provisions will not become effective until the conditions precedent are satisfied.

More unusually, conditions subsequent can be used to achieve the same objective, by providing for the termination of the agreement after it has become effective if the relevant condition is not satisfied by a longstop date.

Whether conditions precedent or conditions subsequent are used, the contract should always provide for a circumstance in which the longstop date is reached without the condition having been satisfied. Will the agreement simply lapse with the parties being responsible for their own costs? What if only one party was responsible for satisfying the condition, will the other party be entitled to compensation? Has a deposit been paid and, if so, are there any circumstances in which it will not be returned?

In the context of a project financing (for example of a power plant or petroleum pipeline) the finance documents will typically require the borrower to obtain, and maintain in effect, all regulatory approvals required for the construction and operation of the project. Obtaining such approvals is likely to be a condition precedent to financial close and a failure to maintain them in effect is likely to be an event of default under the finance documents, allowing the lender to take enforcement steps.

In this case, the parties commonly assumed that the necessary approvals either had been or would be obtained and that the Defendant was in a position to participate in the airlift. The Defendant omitted to build in any protective contractual mechanisms to address the possibility of regulatory approvals failing to materialise whilst also assuming all the risk. Once the full picture emerged it therefore had little choice but to rely upon a defence which is notoriously difficult to make out. The argument of common mistake should therefore be treated with extreme caution - in most cases the courts are likely to favour the sanctity of contract to rendering a contract void ab initio. The case shows the importance of properly providing for circumstances in which the envisaged regulatory approvals are not obtained; parties should ensure that the contractual consequences are clearly set out and provide them with adequate protection